Get Your Financial House in Order
Here’s a list of the financial information your broker and lenders look at when determining if you can get preapproved and obtain a loan.
- Income and documented verification
- How much money can you afford to spend on a mortgage payment each month?
- Debt: How much do you spend paying off debt each month in relation to your gross (pre-tax) monthly income?
- Credit score and any credit events (foreclosures, bankruptcies)
- Assets and cash need to buy a house: Anything you’re using to source your cash to close for a loan (e.g., savings, checking, money market, mutual funds, stocks, bonds, retirement, gifts, trust, net equity)
1. Income and Verification
Lenders need to know how much you make each year and want to see a steady income that is documented for the last two years. This is necessary to qualify for most loans. Be prepared to explain gaps in employment or having changed employment multiple times. We have a list of documents you need and a video that explains important parts of the documentation process.
2. How much money can you afford to spend on a mortgage payment each month?
It depends on who you ask. Some financial advisers will tell you 25% of your gross monthly income. Others might say up to 29%. It might also depend on how much debt you pay off each month and how conservative you want to be with your finances.
You can calculate this range by multiplying your gross monthly income by .25. Then multiple your gross monthly income by .29. This will give you a range between 25% and 29%. [Note: If you’re not sure of you gross monthly income, take your pre-tax annual salary or your annual income and divide by 12.]
Let’s look at an example: Jen and John have a combined gross monthly income of $9,000.
$9,000 x .25 = $2,250 $9000 x .29 = $2,610
Assuming Jen and John have a reasonable debt-to-income ratio (DTI), which we’ll cover next, it looks like they can afford a mortgage payment between $2,250 and $2,610. Some lenders will allow for a higher percentage of your monthly income to go toward housing, but this would be a safe range for this couple.
It’s important to understand that a mortgage payment includes the loan principle, the loan interest, homeowners’ insurance, mortgage insurance, and taxes. It is not just based on the loan principle, so if you use a mortgage calculator, make sure these factors are included in the overall total.
3. How much of your gross monthly income goes toward paying off debt each month?
This question addresses your debt-to-income ratio (DTI). This is important to lenders. The more you spend paying off debt each much, the greater your DTI. The higher your DTI, the greater the risk you might default because you owe too much money and can’t keep up your payments. Every loan program has different guidelines when it comes to DTI. A good rule of thumb is to maintain a DTI of 41%. This is the ideal, and if you can do this, you will be in a good position. That being said, if your DTI is higher, don’t worry. Loan programs set an ideal DTI, but there are many factors that come into play: Assets, credit score, and your down payment.
Calculate your DTI
Add up all your monthly debt payments and divide the total by your gross (pre-tax) monthly income then multiply by 100 and that’s your debt-to-income ratio. Let’s look at an example:
Jen’s and John’s monthly debt includes:
$700 – credit cards
$2100 –current mortgage or rent
$500 – student loans
$500 – car
Their total monthly debt = $3,800. Their gross monthly income is $9,000
3800/9000 = .422 x 100 = DTI of 42.2% (round to 42%)
42% of their monthly income goes toward paying debt.
Although DTI doesn’t take into consideration your other monthly expense (i.e., food, medical, electric, entertainment, home maintenance, furniture), that doesn’t mean you shouldn’t keep these in mind when pricing homes. As you consider how much home you can afford, consider your entire household budget. The last thing you want is to end up with a home you can’t maintain.
If your DTI is high, look for ways to start paying off your debt. One popular approach is to pay off the credit card with the lowest balance first. This is known as the “snowball” method. It gives you a sense of progress and accomplishment and the momentum you need to keep moving forward. The opposite approach is the debt “avalanche” method which pays off credit cards with the highest interest rate first in an effort to save the money you would have paid toward interest.
DTI is a critical part of the loan process. Stay on top of your debt, and you’ll find you have more options when it comes to obtaining a loan.
4. Credit Score
Your credit score represents your credit history. It’s a three-digit number ranging from 300-850 that indicates your creditworthiness and how well you pay back your debts. The higher your score the better.
Your score is based on your credit history which includes late payments, credit utilization (how much credit has been extended to you versus how much you use), collections (defaulted loans or bill payment), new credit opened in a small span of time, and credit events like foreclosures and bankruptcies.
Credit score requirements vary depending on the lender and the type of loan. There are minimum scores, and we’ve listed them below. Keep in mind that these are minimums. When your score is lower, you are considered more of a risk as a borrower. This can impact the interest rates you receive. It never hurts to work on increasing your credit score.
800-850 = Exceptional
740-800 = Very Good
670-740 = Good
580-670 = Fair
300-580 = Poor
(FHA = 580; VA = 580; Conventional= 620; USDA= 640)
What can you do to increase your credit score?
- Keep debt balances low: Debt utilization accounts for 30% of your credit score. Pay down those debts. It will help improve your score.
- Increase credit limits: This will decrease your debt utilization ratio.
- Make payments on time: This is critical. Late payments signal default risk.
- Avoid taking out any new debts or lines of credit.
If you don’t know your credit score, or you’ve never seen your credit report, you may want to get a copy of it. You can obtain a free copy of your credit report every year.
5. Assets and Cash Needed to Close
Lenders need to know that you have the cash needed to buy a house and the assets needed in case you lose your source of income. They will subtract your total debt from your total assets to estimate your net worth. Your assets include cash, cash equivalents, and property. Your income is not considered an asset. When you apply for a loan, you will list your assets. Here are some examples of the documents and information you need to give.
- Most recent 2 months’ bank statements (60 days) complete statement/all pages.
- This includes any source of funds you’re using as assets for this loan (e.g., savings, checking, money market, mutual funds, stocks, bonds, retirement, gifts, trust, net equity)
- List any property you own free and clear, and the taxes and insurance associated with this property.
The total cash needed to purchase a house is known as “cash to close.” That amount will depend on the cost of the home, the loan program, and your down payment. Loan requirements vary. Some loans, like the VA and USDA, actually have 100% financing (no down payment) for those who qualify, but you will still need cash to buy a home under these loan programs. Here are some of the costs associated with buying a home:
Earnest money: 1-2% of purchase price. This is like a deposit. It’s put into escrow when your offer is accepted by the seller and later applied to the sale of the home.
Closing costs: 3-6% of the purchase price. They include a variety of fees: Title, title insurance, escrow, appraisal, credit report, county recording, attorney, mortgage insurance, mortgage lender and broker.
Home inspection: $300-$500
Down payment: 0-20%. Loan program requirements vary.
Cash reserves: 0-6 months’ worth of mortgage payments set aside in savings.
Prepaid property taxes and homeowner insurance: Tax rates and insurance laws vary.
If you’re planning to buy a home, saving for a down payment, closing costs, earnest money, and cash reserves is important.
Here’s an example for a $250,000 home and the cash to close needed for different loan programs and down payment amounts. For this example, we used national averages for insurance and property taxes
| Cash for: | Conventional Loan 3% down | Conventional Loan 20% down | FHA 3.5% down | VA Loan 0% down |
|---|---|---|---|---|
|
Down payment |
$7,500 |
$50,000 |
$8,750 |
$0 |
|
Closing costs (3.5%) |
$8,750 |
$8,750 |
$8,750 |
$8,750 |
|
Cash Reserves |
$3,000 |
$2,200 |
N/A |
N/A |
|
Pre-paid Insurance (1yr)
National average |
$1000 |
$1000 |
$1000 |
$1000 |
|
Property taxes (3 months based on national average) |
$415 |
$415 |
$415 |
$415 |
|
Total Amount
Cash to Close* |
$20,665 |
$63,165 |
$18,915 |
$10,165 |
*This doesn’t account for any credit/refund for earnest money
Summary
Buying a home is one of the most important investments you’ll make in your lifetime. The more you know about your finances and the process, the better off you’ll be. If you’re ready to apply, gather the documents you’ll need and apply for a loan, so you can find out the amount for which you can get preapproved and start shopping for that new house.
